Speculative Rush, Redux

Posted At 8:50 AM EST

Good morning...We begin the day with the pre-market futures showing a bit of weakness, but they've been chopping back and forth within a fairly tight early morning range.  The morning's big economic reports were better than expected (the headline numbers were, at least) but so far the reaction has been limp.

On June 5th, we looked at a ratio of assets in Nasdaq 100 (NDX) funds at the Rydex family of mutual funds, comparing the amount of money in long funds (that profit if the NDX rises) versus short funds (that profit if the NDX falls).

Those indicators showed a rush into technology funds, which has normally been a warning sign for the market.  Yesterday we saw the same kind of behavior in the S&P 500 funds.

The chart below shows the ratio of assets in bullish index funds versus bearish index funds for both the un-leveraged and leveraged funds that Rydex offers, including both S&P and NDX funds.

As of yesterday, traders had placed 2.5 times as much money in bull funds as bear funds, a level that has been matched only a couple of times in the past five years - October 31, 2007 and a few days at the end of December 2004.  In the leveraged funds, the ratio shot up to 2.4, the most extreme reading since November 2001.

Like the other signs of speculation we've discussed, prior signals didn't necessarily coincide with an exact peak in the market.  In early 2006, for example, the S&P continued to meander higher for months, but eventually did give back all of those gains in a short amount of time.

Not to harp on the Nasdaq too much, but in addition to the speculative shift in Rydex assets, the bump up in penny stock trading and the curious case of an overbought New High / New Low Ratio with so few new highs, we're also seeing a surge in volume on that exchange compared to the NYSE.

We've looked at this indicator a number of times over the years, and it has remained a pretty reliable contrary gauge.  Despite problems like increasing off-exchange volume, when we see this ratio dip below 1.0 or jump above 2.0, the market has typically responded in a reliable fashion.

The chart below shows its performance during the current bear market.

If you try to re-create this chart, then you will almost certainly get different values.  The data we use for this comes from Reuters, and uses volume on the exchanges only.  It does not include composite volume.

Let's zoom out and look at as much history as we have available.  Then the reason for concern becomes even more clear.

Granted, at the market peaks in 2000 and 2007/2008, we saw this speculative volume percolate for months on end.  Now, we've only seen it for three days.  But we were also trading at or near all-time highs back then, while now we're...not.

Like other indications of excessive speculation we've touched on over the past few weeks, spikes in this ratio didn't necessarily signal an immediate decline, but they did give us good heads-up that whatever short-term gains were made going forward were likely to be given back (and sooner rather than later).

Bottom line - Intermediate-term Outlook:  Neutral  (since April 9, SPX 843)

Beginning in early March, we discussed a large number of reasons to expect an imminent rally of one to three months' duration.  Some of those studies were even more positive, and suggested not just a rally, but possibly a new bull market.

During mid-April, several of our measures like the Indicator Score and Dumb Money Confidence reached levels that usually result in either a flattening out of the price rally, or an outright decline, especially during a bear market.

But the market held up extremely well in spite of some of these overbought types of indications.  This is very rare during an ongoing bear market, and is important to keep in mind especially given many of the "this time is different" kinds of studies we reiterated in early May.

While there have been - and continue to be - many reasons to consider this rally something different than we'd seen previously in the bear market, I've been looking for the S&P to run into trouble if it traded into 940-950, which it happened last week.  I wasn't expecting any kind of waterfall decline to new lows, just more of a pullback than we'd seen.

The S&P did fail on its first attempt to get over that hump, but on Wednesday afternoon we discussed the first pullback to the breakout over 920ish, and the market once again passed with flying colors, taking us once again into 950ish by Friday.  It's hard to become too negative on the market as long as it continues to do nothing wrong.

What's made this juncture so difficult is that despite so many signs of "this time is different" and the market doing nothing wrong, there are some troubling signs out there.  We touched on a couple very recently, like the surge in speculative trading and the return of bullish opinion.  Because of that, I've been leery of the S&P's chances to hold a breakout above 950.

With so many conflicting signs (like the prior two paragraphs), I'm simply going to back off and see how the market reacts.  In other words, I just don't know.

Bottom line - Short-term Outlook:   Neutral  (since June 3, SPX 924)

The range over the past few days has been incredibly tight, especially on a closing basis.  The S&P has closed within 0.35% of the prior day for each of the past four days.  Not only that, but the distance from the highest high to the lowest low over the past 8 days is only 27 points.

I can only find a few instances since 1982 when the futures have closed with 0.35% for 4 straight days while over the past 8 days the high-low range has been within 1.5 times over the Average True Range of the past three months.  Those dates were 08/05/93, 05/31/94, 07/26/94, 01/09/95, 08/21/96, 08/29/00 and 08/31/06.

There isn't much consistent about them going forward, except that very often, the first attempted move out of the consolidation was a fakeout, and we soon saw another move in the opposite direction.

Let's take a look at the latest instance, from August 31, 2006, as an example.

We looked at something similar to this a couple of weeks ago on a weekly basis, suggesting that a breakout would likely have trouble making much headway.  That move hasn't "failed" yet per se, but it's something to be aware of, particularly now that we have essentially the same setup on a daily basis.

Over the past couple of weeks, the market has fallen from overbought conditions near previous highs, and rallied from oversold conditions near previous lows.  All within a very tight range.  At some point, obviously, that's going to change, but based on the market's behavior when coming out of a consolidation, I won't necessarily trust that first breakout or breakdown.

Until we see either, and with no real short-term extremes to speak of, for now it's just sitting and watching to see which side gives way first.

All the best,